Revenue recognition: A whole new world

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1 Revenue recognition: A whole new world Prepared by: Brian H. Marshall, Partner, National Professional Standards Group, RSM US LLP brian.marshall@rsmus.com, June 2014 UPDATE: To help address issues identified by entities as they implement the new guidance, the FASB and International Accounting Standards Board (IASB) established the Joint Transition Resource Group (TRG). Constituents submit issues to the TRG for discussion and to the extent the TRG discussions on an issue lead the FASB and (or) IASB to believe additional standard setting is necessary, they add the issue to their respective agendas. Both the FASB and IASB have added projects to their agendas to address several of the TRG issues. The FASB projects are expected to change or clarify the new revenue recognition guidance. The effects of any such changes or clarifications on the new revenue recognition guidance will be reflected in this white paper after they are finalized. In the meantime, for additional information about the TRG issues discussed by the FASB and their status, refer to our article, Revenue recognition: In motion. For additional information about the TRG issues discussed by the IASB and their status, refer to the IASB s website. Overview On May 28, 2014, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) issued substantially converged final standards on revenue recognition. These final standards are the culmination of a joint project between the Boards that has spanned many years. The FASB s Accounting Standards Update (ASU) , Revenue from Contracts with Customers (Topic 606), was issued in three parts: (a) Section A, Summary and Amendments That Create Revenue from Contracts with Customers (Topic 606) and Other Assets and Deferred Costs Contracts with Customers

2 (Subtopic ); (b) Section B, Conforming Amendments to Other Topics and Subtopics in the Codification and Status Tables; and (c) Section C, Background Information and Basis for Conclusions. ASU provides a robust framework for addressing revenue recognition issues and, upon its effective date, replaces almost all existing revenue recognition guidance, including industry-specific guidance, in current U.S. generally accepted accounting principles (GAAP) (hereinafter referred to as legacy GAAP). While there has not been an indication from the Securities and Exchange Commission (SEC) staff, we expect significant changes will be made to Staff Accounting Bulletin Topic 13, Revenue Recognition (also part of legacy GAAP for public entities), which could include it being superseded. As a result of these wholesale changes, when the new guidance is implemented, there should be improved comparability of revenue recognition practices across entities, industries, jurisdictions and capital markets. Given the broad applicability and potentially significant ramifications of the guidance in the ASU, the FASB provided significantly delayed effective dates for its guidance. The ASU is effective in 2017 for calendar year-end public entities, which includes: (a) public business entities, (b) not-forprofit entities that have issued, or are conduit bond obligors for, securities that are traded, listed or quoted on an exchange or an over-the-counter market and (c) employee benefit plans that file or furnish financial statements to the SEC. For all other calendar year-end entities, the ASU is effective in Even with those delayed effective dates, it is not too early to start identifying how the guidance in the ASU will affect an entity s revenue recognition policies, particularly if the entity plans on electing the transition method that requires retrospective application to all periods presented and (or) if the entity has multiyear contract terms with its customers. The information in this white paper should be used to gain an initial understanding of the guidance in the ASU and whether this guidance could result in significant changes to the timing and amount of revenue recognized by an entity. Discussion is provided on the ASU s scope, core principle and key steps, presentation and disclosure requirements and effective date and transition provisions. In addition, application of the ASU s principles to specific terms in a customer contract or specific types of transactions is also discussed. Significant changes expected The policies used by almost all entities to account for revenue and certain related costs will be affected by the new guidance added by the ASU to the FASB s Accounting Standards Codification (ASC), which is primarily captured in ASC 606 and ASC The degree of change to a specific entity s revenue recognition policies and the effects the changes have on the entity s financial statements vary depending on the nature and terms of the entity s revenue-generating transactions. In addition, entities in some industries will likely be affected by the ASU more than entities in other industries. For example, the revenue recognition policies for normal course transactions of a traditional retailer need to change so that they are aligned with the principles and guidance in ASC 606; however, those changes may not have a significant effect on the timing and amount of revenue recognized by the retailer. Conversely, the effects of the changes on a software entity s revenue recognition policies to align them with the principles and guidance in ASC 606 may result in significant changes to the timing and amount of revenue recognized by the entity. Significant changes related to an entity s accounting for its revenue-generating transactions and related costs could result from applying the guidance in the ASU for many reasons, including because of its: Focus on the transfer of control instead of the transfer of risks and rewards (which is used pervasively in legacy GAAP) for purposes of determining when to recognize revenue Use of a model that may result in estimates of variable consideration being included in the transaction price (and recognized as revenue) sooner than they would be under legacy GAAP Incorporation of the time value of money into the measurement of revenue (with limited exceptions) when customer contracts include a significant financing component due to advance payments or deferred payments, which is only done today under legacy GAAP in the context of accounting for long-term receivables 2

3 Use of one comprehensive approach to account for all licenses and rights to use intellectual property (IP) instead of the limited-scope industry-specific models in legacy GAAP Use of one comprehensive approach to account for multiple-element arrangements instead of the general model (i.e., ASC , Revenue Recognition Multiple-Element Arrangements ) and industry-specific models in legacy GAAP Requirement to capitalize certain costs related to a contract with the customer (e.g., sales commissions, setup costs) under certain circumstances instead of having the option to do so in certain cases under legacy GAAP In addition, there are many new disclosure requirements that will cause the volume of revenuerelated information disclosed in the financial statements to significantly increase, particularly for public entities. These and other changes are highlighted throughout the remainder of this white paper. Whether, and the degree to which, any of the changes introduced by the ASU affect an entity can only be determined after performing a comprehensive analysis of customer contracts in the context of the new guidance. Scope ASC 606 addresses revenue from contracts with customers. Revenue is defined in the Master Glossary of the ASC as Inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity s ongoing major or central operations. While the scope of ASC 606 is limited to revenue, as discussed later, the model in ASC 606 is also applicable to certain sales of nonfinancial assets that do not give rise to revenue. General scope requirements All revenue-generating customer contracts fall within the scope of ASC 606 except for the following: (a) lease contracts, (b) insurance contracts, (c) various contractual rights or obligations related to financial instruments, (d) guarantees other than warranties and (e) certain nonmonetary exchanges. Other applicable guidance exists in the ASC related to the accounting for these types of contracts. There are no other scope exceptions in ASC 606 for certain industries that have had their own customer contract-based revenue recognition guidance in legacy GAAP. Examples of industries that are subject to ASC 606 and that no longer have their own separate industry-specific revenue recognition guidance include the construction, real estate, software and franchising industries. Legacy GAAP on revenue recognition was developed in a piecemeal manner. In many cases, specific guidance was developed for a particular industry, transaction or contractual provision, which resulted in limited applicability of the related guidance. One of the most significant aspects of ASC 606 is its broad applicability and the fact that it is superseding virtually all revenue-related legacy GAAP, including the vast majority of its industry-specific guidance. Definition of a customer Customer is defined in ASC as a party that has contracted with an entity to obtain goods or services that are an output of the entity s ordinary activities in exchange for consideration. In most cases, applying this definition to determine whether the counterparty to a contract is a customer will not require much analysis. In other cases, such as contracts with a collaborator or partner (e.g., two companies agree to collaborate on the development of a new drug), more analysis is required to determine whether the collaborator or partner meets the definition of a customer. 3

4 In certain circumstances, revenue can be generated by contracts with counterparties that are not customers (e.g., income replacement and subsidy programs in the agriculture industry, alternative revenue programs of utilities and contributions made to not-for-profit entities). Because this revenue does not come from contracts with customers, the guidance in ASC 606 does not apply and the guidance in legacy GAAP remains applicable. Customer contracts only partially in the scope of ASC 606 A contract may be partially within the scope of ASC 606 and partially within the scope of other guidance in the ASC. In this situation, the entity is required to separate and measure portions of a contract within the scope of other guidance in accordance with that guidance. If the other guidance does not state how to separate and (or) measure portions of a contract within its scope, the guidance in ASC 606 is applied. The amount allocated to the portion of a contract within the scope of other guidance is recognized based on that other guidance, and the amount allocated to the remaining portion is recognized in accordance with ASC 606. This approach is largely consistent with legacy GAAP on multiple-element arrangements. For example, a customer contract that includes a lease and maintenance services should be separated into a lease portion (which should be accounted for in accordance with ASC 840, Leases ) and a maintenance portion (which should be accounted for in accordance with ASC 606), with the transaction price allocated on a relative standalone selling price basis because ASC 840 indicates that ASC 606 should be applied to allocate the transaction price to the lease and maintenance portions of the contract. As another example, a customer contract that includes a guarantee and other goods and services should initially be separated into a guarantee portion and a goods and services portion by measuring and recognizing the guarantee at its fair value as required by ASC 460, Guarantees. The remaining goods and services and consideration in the contract should be accounted for in accordance with ASC 606. Sales of nonfinancial assets that are not an output of the entity s ordinary activities An entity may transfer or sell nonfinancial tangible or intangible assets (or in substance nonfinancial tangible or intangible assets) that are not an output of its ordinary activities. For example, a distributor may sell its used delivery trucks to a third party, or a manufacturer may sell some of its used manufacturing equipment to a third party. With limited exceptions, even though the proceeds from such sales do not meet the definition of revenue (because the nonfinancial assets being sold are not an output of the entity s ordinary activities), the guidance in ASC 606 related to recognition, measurement and whether a contract exists should still be applied in determining the timing and amount of the gain or loss recognized on such sales. So, for example, the guidance in ASC 606 should be used in determining the amount of variable consideration recognized as part of the gain or loss that results from the distributor selling its delivery trucks. In general, legacy GAAP related to revenue recognition is only applied to revenuegenerating transactions. Key aspects of ASC 606 should be applied to more than just revenue-generating transactions. This creates the potential for significant changes in how an entity recognizes gains or losses on the sale of a nonfinancial asset that is not an output of the entity s ordinary activities. 4

5 Core principle and key steps The core principle included in ASC is to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASC 606 sets out the following five steps for an entity to use when applying the core principle to its customer contracts: Identify the contract with a customer Identify the performance obligations in the contract Determine the transaction price Allocate the transaction price to the performance obligations Recognize revenue when (or as) each performance obligation is satisfied An entity should consistently apply the guidance in ASC 606 to similar contracts and in similar situations. Identify the contract with a customer (Step 1) Identify the contract with a customer General requirements of identifying the customer contract Because ASC 606 provides guidance on how an entity should account for contracts with its customers, it is important to determine whether a customer contract exists. A contract is defined in ASC as an agreement between two or more parties that creates enforceable rights and obligations. By definition, an agreement (whether written, oral or implied based on the entity s usual business practices) must be enforceable for it to be considered a contract. The enforceability of a right or obligation is a legal determination. An entity s enforceable rights and obligations in a revenuegenerating transaction typically include its obligation to provide specific goods or services to the customer and its right to receive payment for the specific goods or services provided. An additional consideration in evaluating whether there is a customer contract for accounting purposes relates to whether the agreement provides the unilateral, enforceable right to each party to terminate the contract with no compensation to the other party if it is wholly unperformed. If both parties have such a right, a contract does not exist for accounting purposes. Wholly unperformed means that the entity has not satisfied any part of its performance obligations and the customer has not paid or is not obligated to pay any of the related consideration. The existence of a customer contract is not enough in and of itself to require application of ASC 606 to the contract. Only if a customer contract meets the following criteria should it be accounted for in accordance with ASC 606: Commercial substance exists Approvals have been obtained and a commitment to perform exists on the part of both parties Rights of both parties are identifiable Payment terms are identifiable Collection of the amount to which the entity will be entitled is probable (i.e., likely to occur) If a contract meets all of these criteria, the criteria only need to be reassessed if there is a significant change in circumstances. The reassessment focuses only on those rights and obligations that have not yet transferred to the customer. As a result, the reassessment could not result in the reversal of any revenue, receivables or contract assets recognized before the significant change in circumstances. In situations in which one or more of the criteria is not met at contract inception, the entity should reassess the criteria each reporting period (as necessary) to determine whether all of the criteria subsequently are met. At the point in time that all of the criteria are met, ASC 606 is applied. Otherwise, the entity recognizes a liability for any consideration received and only recognizes 5

6 that liability as revenue when either: (a) it has no remaining performance obligations and it has received all, or substantially all, of the amounts promised by the customer and those amounts are nonrefundable or (b) the amounts received from the customer are nonrefundable and cancellation of the contract has occurred. In many cases, legacy GAAP requires persuasive evidence of an arrangement to exist before revenue can be recognized. While there are many similarities between how that requirement is applied in practice and the general requirements of identifying the customer contract in ASC 606, there are also some differences that could affect the timing of revenue recognition, such as the basis for determining whether a contract has been properly approved. Collection is probable To account for a customer contract in accordance with ASC 606, an entity must be able to conclude that collection of the amount to which it will be entitled is probable (i.e., likely to occur). For this purpose, only the customer s ability and intention to pay is considered. Before evaluating the likelihood of collection, the entity must determine the transaction price (which is the amount of consideration to which an entity expects to be entitled). As discussed later, an entity considers a number of factors in estimating the transaction price, including whether: (a) the entity intends to offer the customer a price concession or (b) the customer has a valid expectation of receiving a price concession based on the entity s customary business practices, published policies or specific statements. In general, the entity does not take the customer s credit risk into consideration when estimating the transaction price. The only exception relates to customer contracts with a significant financing component, which requires a discount rate that reflects the customer s credit risk to be used in estimating the transaction price. Once the entity determines the transaction price, it evaluates the likelihood of collecting that amount. If the entity cannot conclude that collection of the transaction price is probable, then the customer contract does not meet one of the required criteria that must be met to apply the revenue recognition model in ASC 606. As a result, revenue recognition under that contract is delayed as discussed earlier. If an entity concludes that collection of the transaction price is probable and there is a subsequent change in circumstances that affects that conclusion, the entity needs to consider the following: Is the change in circumstances significant? If so, the entity needs to reassess whether the likelihood of collecting the remaining transaction price (i.e., the part of the transaction price not yet recognized as revenue) is still probable. An example of a significant change in circumstances related to whether collectibility continues to be probable is a significant deterioration in a customer s credit risk and ability to access credit due to the loss of major customers. Does the change in circumstances affect any receivable recorded for the customer contract? After a receivable (which is an unconditional right to consideration) is recognized in conjunction with the accounting for a customer contract in accordance with ASC 606, the subsequent accounting for that receivable is based on the guidance in ASC 310, Receivables. Any credit losses recognized in accordance with ASC 310 are presented as bad debt expense (and not a reduction of revenue). As discussed later, other changes in circumstances could affect the estimated transaction price and, as a result, the amount of revenue recognized. To illustrate application of this guidance, consider a situation in which the entity s stated price for a product or service is $5,000. However, the entity intends to offer a price concession of $1,000 because establishing a positive relationship with this customer could help forge relationships with other potential customers. Assuming no other factors exist that could affect the transaction price, the entity concludes that the amount it expects to be entitled to (i.e., the transaction price) is $4,000. The entity must now evaluate whether collection of the transaction price of $4,000 is probable. If it is probable, the entity would recognize revenue of $4,000 when it satisfies the 6

7 related performance obligation(s). If collection is not probable (either in whole or in part), the entity would not recognize any revenue until collection is probable and ASC 606 is applied or until one of the following occurs: (a) the entity has no remaining performance obligations and it has received all, or substantially all, of the $4,000 and it is nonrefundable or (b) the amounts received from the customer are nonrefundable and cancellation of the contract has occurred. Assume the entity concludes that collection of $4,000 is probable. If there is a change in circumstances that affects the customer s ability to pay that causes an entity to conclude it will only be able to collect $2,500, it should recognize a credit loss of $1,500 in accordance with ASC 310 as bad debt expense. Alternatively, if there is a change in circumstances that causes an entity to change the amount of price concession offered to the customer, that change is reflected in the transaction price and, ultimately, the amount of revenue recognized. Combining contracts While ASC 606 generally applies to individual contracts, criteria are provided to assess whether individual contracts with the same customer (or parties related to the customer) that are entered into at or near the same time should be combined for accounting purposes. If one or more of the following criteria are met, individual contracts with the same customer (or parties related to the customer) that are entered into at or near the same time are combined for accounting purposes: The contracts were negotiated as a package and share the same commercial objective. The consideration to be paid under one contract is tied to the other contract s price or performance. The contracts include goods and (or) services that represent a single performance obligation. In addition, a practical expedient allows the guidance in ASC 606 to be applied to a portfolio of similar contracts if doing so is not reasonably expected to result in materially different outcomes compared to individually accounting for the contracts. When a contract is referred to in this white paper, it could mean a standalone contract or two or more contracts combined based on the preceding guidance. Contract modifications Contract modifications occur when the entity and its customer agree to add or change enforceable rights and obligations in the contract (e.g., changes to scope and [or] price). Contract modifications must be properly approved by both parties before the entity accounts for the modification. If scope-related additions or changes in a contract modification have been properly approved, but the price-related changes have not yet been properly approved, the entity applies the variable consideration guidance in ASC 606 for purposes of estimating the transaction price. The accounting model applied to a contract modification under ASC 606 depends on a number of factors, including the pricing of the modification, whether any new products or services added by the modification are distinct and whether any of the remaining goods or services are part of a partially satisfied single performance obligation. A contract modification could be accounted for as any of the following depending on the facts and circumstances: (a) a separate contract, (b) the termination of one contract and execution of a new contract (which results in prospective treatment) or (c) part of the original contract (which could result in recognition of a cumulative catch-up adjustment). Identify the performance obligations in the contract Identify the performance obligations in the contract (Step 2) Identifying the performance obligations in the contract establishes the units of account to which the transaction price should be allocated and for which revenue is recognized. The first step in identifying the performance obligations in the contract is to identify all of the promises to provide goods or services in the contract. Once that step is complete, criteria are applied to determine whether the promises to provide goods or services should be treated as performance obligations and accounted for separately. 7

8 Identifying promises to transfer goods or services Promises to transfer goods or services come in a variety of shapes and sizes. Some are obvious, such as the goods sold by a manufacturer or retailer, the cleaning services provided by a professional cleaner and the software license provided by a software company. Others are less obvious, such as a when-and-if-available software upgrade right and the option to purchase an additional good or service in the future at a discount. The key is for an entity to scrutinize its customer contracts and identify all of the promises to transfer goods or services to the customer. Consideration also needs to be given to whether there are promises to transfer goods or services that arise out of an entity s customary business practices instead of an explicit contract provision. If an entity s customary business practice, published policy or specific statement creates a valid expectation on the customer s part to receive a good or service from the entity (e.g., training on how to use purchased equipment), a promise to transfer goods or services exists. Some activities performed by the entity, such as setup activities, do not transfer a good or service to the customer. Instead, those activities are necessary for the entity to fulfill the contract and do not themselves represent a good or service transferred to the customer. As a result, they do not represent a performance obligation. While legacy GAAP includes various multiple-element arrangement models, there is very little discussion in those models with respect to what constitutes an element or deliverable. In addition, the concept of an inconsequential or perfunctory deliverable does not exist in ASC 606. For these reasons, the introduction of guidance on the subject of identifying promises to transfer goods or services could ultimately affect the units of account identified by an entity for revenue recognition purposes. Separating promises to transfer goods or services into performance obligations If there is more than one promise to transfer goods or services in a contract, consideration must be given to whether the promises to transfer goods or services should each be considered performance obligations and treated separately for accounting purposes. The determining factor in this analysis is whether each promised good or service is distinct. If a promised good or service meets both of the following criteria, it is considered distinct and accounted for separately as a performance obligation: Capable of being distinct. If a customer can benefit from the promised good or service on its own or by combining it with other resources readily available to the customer, then the good or service is capable of being distinct. Distinct within the context of the contract. If the promised good or service is separately identifiable from the contract s other promised goods or services, it is distinct within the context of the contract. The evaluation of whether a promised good or service is distinct should be performed at contract inception for each promised good or service in the contract. A promised good or service is capable of being distinct when the entity regularly sells that good or service separately or when the customer can generate an economic benefit from using, consuming, selling or otherwise holding the good or service for economic benefit. The ability to sell the good or service for scrap value would not, in and of itself, support a conclusion that the promised good or service is capable of being distinct. If the customer cannot benefit from the promised good or service on its own, it should consider whether it could benefit from the promised good or service if it combined the good or service with other readily available resources. For a resource to be readily available to the customer, it must be sold separately either by the entity or another party or it must be a good or service that the customer has already obtained as a result of either a contract with the entity (including the contract under evaluation) or another transaction or event. For example, if an entity sells a piece of complex manufacturing equipment and services to install the equipment and the entity is the only party that can install the equipment, the equipment is not capable of being distinct because the customer cannot benefit from the equipment on its own or by combining it with other resources readily available to it. 8

9 Indicators are provided to assist in determining whether promised goods or services are distinct within the context of the contract. These indicators focus on the level of integration, modification or customization that exists with respect to the promised goods or services, as well as how interrelated the promised goods or services are and how dependent they are on each other. For example, all of the promised goods and services involved in the entity s construction of a building for a customer would likely not be considered distinct within the context of the contract because of the level of integration required to transform those goods and services into the building for which the customer contracted. For another example, if a customer contract includes a license for the entity s software as well as installation services that require substantial customization of the software, the software and installation may not be considered distinct within the context of the contract. If a promised good or service is distinct, it is considered a performance obligation and accounted for separately. However, a series of distinct promised goods or services that are substantially the same, may also be considered a single performance obligation and accounted for as one unit of account if each of the goods or services has the same pattern of transfer to the customer because: (a) each of the goods or services would otherwise be considered satisfied over time and (b) the entity would otherwise have used the same method of measuring progress toward completion for each of the goods or services. An example of a series of distinct promised goods or services that could be considered a single performance obligation includes weekly cleaning services for a oneyear period. Other examples may involve contracts for transaction processing services or delivery of electricity. Promised goods or services that are not distinct are combined until the group of promised goods or services is considered distinct, at which point that group is considered a performance obligation and accounted for separately. It is possible that all of the promised goods or services in the contract might have to be accounted for as a single performance obligation. This happens when none of the promised goods or services are considered distinct on their own or together with less than all of the other promised goods or services in the customer contract. A practical expedient allows ASC 606 to be applied to a portfolio of similar performance obligations across multiple customers for accounting purposes if doing so is not reasonably expected to result in materially different outcomes compared to individually accounting for the performance obligations. In legacy GAAP, there is a general multiple-element arrangement model as well as models that focus on specific industries (e.g., software, construction). The criteria used to determine whether an element should be treated separately for accounting purposes under these models are different from the criteria in ASC 606. For example, under the general multiple-element arrangement model in legacy GAAP, a delivered element must have standalone value to the customer to be accounted for separately. If the element is sold separately by the entity or another party, it is considered to have standalone value to the customer. The analysis of whether a promised good or service is distinct under ASC 606 requires consideration of more factors than just whether the promised good or service is sold separately. This difference could lead to the identification of different units of account for revenue recognition purposes. Determine the transaction price (Step 3) Determine the transaction price General requirements of determining the transaction price Transaction price is defined in ASC as the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, some sales taxes). In addition to the contract terms, the entity s customary business practices should also be taken into consideration in determining the transaction price. The entity should assume that the contract will be fulfilled in accordance with its terms and customary business practices for purposes of determining the transaction price. In other words, the entity should not assume or consider cancellation, renewal or modification of the contract. 9

10 The transaction price is determined at contract inception and should include the fixed cash consideration as well as any noncash consideration promised by the customer. The transaction price should also reflect the expected effects of any variable consideration (subject to an overall constraint), such as performance bonuses, rebates and penalties. Depending on the facts and circumstances, the transaction price may also need to reflect the effects of the time value of money and consideration payable to the customer. Noncash consideration If the fair value of the noncash consideration (or the promise of noncash consideration) can be reasonably estimated, then its fair value is included in the transaction price. Otherwise, the entity should indirectly determine its fair value using the standalone selling prices of the goods or services being provided to the customer. The fair value of the noncash consideration may vary due to its form (e.g., a share of the customer s stock) or for other reasons (e.g., the entity s performance). If the fair value varies for reasons other than the form of the noncash consideration, it is subject to the constraint on variable consideration. A customer may provide noncash consideration to the entity in the form of contributed goods or services that the entity will use in fulfilling its obligations to the customer. In that situation, the question arises as to whether the entity should reflect the fair value of those contributed goods or services in the transaction price. The answer to that question depends on whether the entity obtains control of those goods or services. If it does, then their fair value is included in the transaction price. Variable consideration Variable consideration can take many forms refunds, returns, discounts, rebates, performance bonuses, milestone payments, penalties, contract claims and price concessions, just to name a few. The variability in the amount of consideration payable by the customer may be stated in the contract, or it may be caused by an implicit price concession that the entity intends to offer the customer or that the customer has a valid expectation of receiving based on the entity s customary business practices, published policies or specific statements (e.g., the discount from standard rates that a hospital intends to offer a self-pay patient). The variability in the consideration could affect whether the entity is entitled to the consideration (e.g., occurrence or nonoccurrence of meeting a deadline to which a performance bonus is tied) and (or) the specific amount of consideration the customer will ultimately have to pay (e.g., the quantity of customer purchases to which a volume discount is applied). With one exception, an estimate of the variable consideration that the entity expects to be entitled to should be included in the transaction price to the extent it is probable that its inclusion will not result in a significant reversal of cumulative revenue recognized. The exception relates to sales and usage-based royalties on licenses of IP, which should not be included in the transaction price until the later of: (a) the resolution of the related uncertainty (i.e., sales or usage occur) or (b) the satisfaction of the related performance obligation in whole or in part. It is important to note that this exception only applies to licenses of IP, not outright sales of IP. It is also important to note that this exception should not be used by analogy for other types of variable consideration or other types of promised goods or services. To determine the amount of variable consideration that should be included in the transaction price, the entity first needs to estimate the amount to which it expects to be entitled using one of two methods, which are the expected value method and the most likely amount method. The method an entity should use depends on which method better predicts the amount of variable consideration in the particular set of facts and circumstances. To the extent a customer contract includes two different variable payments based on the resolution of different uncertainties, the facts and circumstances may support using different methods to estimate the variable consideration expected upon the resolution of each uncertainty. Once the entity has estimated the amount of variable consideration to which it expects to be entitled, it then needs to apply a constraint focused on whether it is probable that the inclusion of the estimated variable consideration in the transaction price will not result in a significant reversal 10

11 of cumulative revenue recognized for the contract. Only estimated variable consideration for which it is probable that its inclusion in the transaction price will not result in a significant reversal of cumulative revenue recognized should be included in the transaction price. If it is probable that a significant reversal of cumulative revenue recognized will not occur with respect to just a portion of the estimated variable consideration to which the entity expects to be entitled, that portion would be included in the transaction price. ASC 606 provides indicators to help in assessing whether it is probable that a significant reversal of cumulative revenue recognized will not occur. Some of these indicators consider: (a) whether the variability is caused by factors outside the entity s influence, (b) the length of time until resolution of the uncertainty, (c) the nature and extent of the entity s experience with similar contracts, (d) the entity s past practices with respect to offering price concessions or changing payment terms and (e) the number and range of possible outcomes. The estimate of variable consideration must be reassessed each reporting period until the underlying uncertainty is resolved. Any changes in the estimate of variable consideration are treated the same as any other changes in the transaction price. The method(s) used to initially estimate the variable consideration included in the transaction price should also be used when the estimate is reassessed each reporting period. One of the criteria considered under certain legacy GAAP for purposes of revenue recognition is whetherthe fee is fixed or determinable. Application of this criterion and other specific guidance related to variable consideration results in the recognition of most variable consideration when the related contingency is resolved. While ASC 606 includes an overall constraint on the amount of variable consideration included in the transaction price, earlier recognition of variable consideration is still expected to occur in many cases under ASC 606 compared to certain legacy GAAP. Time value of money The time value of money is taken into consideration in determining the transaction price if the customer contract includes a significant implicit or explicit benefit of financing to either the entity or the customer (i.e., a significant financing component), unless the entity qualifies for and elects to apply a practical expedient that allows it to ignore the time value of money. It is important to note that a financing component may exist in a customer contract when the payment terms provide for advance and (or) deferred payments. In other words, a financing component in a customer contract could result in the entity recognizing interest income or expense. All of the relevant facts and circumstances related to the customer contract need to be considered in determining whether it includes a significant financing component. For example, an entity should consider whether there is a difference between the amount the customer would have had to (i.e., hypothetically) pay for the promised goods or services in cash upon their transfer and the amount the customer is paying for those goods or services based on the payment terms in the contract. An entity should also consider the amount of time that will pass between when the promised goods or services are transferred to the customer and when the customer pays for those goods or services along with the relevant prevailing interest rates. ASC 606 specifically indicates that a significant financing component does not exist in any of the following situations: (a) the customer makes an advance payment and the timing of transferring the promised goods or services to the customer is at the customer s discretion (e.g., prepaid phone cards), (b) there is substantial variable consideration and payment of that consideration is contingent on the resolution of an uncertainty that is not substantially in the entity s or customer s control (e.g., sales-based royalty) or (c) there are reasons not related to financing that justify the difference in the cash selling prices of the promised goods or services and the promised consideration (e.g., deferred payment terms or contract holdbacks may protect the customer if the entity fails to satisfy some or all of its contractual obligations). 11

12 If a customer contract has a significant financing component, application of a practical expedient to not consider the time value of money in estimating the transaction price can be considered if the entity expects the difference between the following two events to be one year or less at contract inception: (a) the entity s transfer of the promised goods or services to the customer and (b) customer payment for those goods or services. When assessing whether the practical expedient can be applied, it is important to focus on these two events and not the duration of the contract in its totality. If an entity chooses not to consider the practical expedient or concludes that the practical expedient cannot be applied to its facts and circumstances, then the time value of money must be taken into consideration in estimating the transaction price by using an appropriate discount rate to adjust the promised consideration. The discount rate should take into consideration the credit risk of the entity (when advance payments are involved) or the customer (when deferred payments are involved). Interest income or expense should only be recognized to the extent a contract asset (or receivable) or contract liability has been recognized for the customer contract. The relevant guidance in ASC , Interest Imputation of Interest, should be used to: (a) present any discount or premium in the financial statements and (b) apply the interest method. The income statement effects of reflecting the time value of money in the transaction price should be presented separately from the revenue for the portion of the transaction price attributed to the promised goods or services. The income statement effects when the time value of money results in a cost (e.g., advance payments) should be reflected as interest expense. Under legacy GAAP, receivables for which the payment is not due for more than one year are generally discounted to reflect the time value of money. However, the same is not true for advance payments, which ASC 606 requires to be adjusted for the time value of money under certain circumstances. This could represent a significant change for entities that regularly receive long-term advance payments from their customers. Consideration payable to the customer Customer contracts may include provisions in which the entity is explicitly required to pay consideration to its customer (e.g., manufacturer s payment of slotting fees to a retailer customer) or its customers customers (e.g., manufacturer s payment of rebates to consumers). In addition, future payments to customers may be implied based on an entity s past practices. In these situations, an entity may or may not receive something in return from its customer for these payments (e.g., manufacturer pays retailer customer for cooperative advertising or product placement at eye level). Consideration paid by the entity to its customers or its customers customers is reflected as a reduction of the transaction price (and, as a result, a reduction of revenue) unless the entity receives something in return for that consideration that is distinct. If consideration payable to a customer is variable, it should be measured consistent with the guidance generally applicable to variable consideration. If the entity receives a good or service that is distinct, it has to determine if its fair value can be reasonably estimated. If the entity cannot reasonably estimate the fair value of the distinct good or service it receives from the customer, then the payment made to the customer is treated as a reduction of the transaction price. Otherwise, the cost of the good or service received by the entity is the lesser of the fair value of the good or service provided to the entity and the amount payable to the customer by the entity. This cost is accounted for in the same manner as if the entity had bought the good or service from a party other than its customer. Any excess of the amount payable to the customer over the fair value of the good or service it receives from its customer is treated as a reduction of the transaction price. 12

13 If the consideration payable by the entity to its customers or customers customers should be treated as a reduction in the transaction price, that reduction of revenue should be reflected upon the later of: (a) when the revenue for the related goods or services is recognized and (b) when consideration is paid or promised (which includes payments made only upon the occurrence of a future event). The approach to accounting for consideration payable to the customer in ASC 606 is largely consistent with the approach in legacy GAAP. Allocate the transaction price to the performance obligations Allocate the transaction price to the performance obligations (Step 4) If a customer contract has more than one performance obligation, the transaction price should generally be allocated to each performance obligation based on the standalone selling prices of each performance obligation in relation to the total of those standalone selling prices (i.e., on a relative standalone selling price basis). Exceptions to the relative standalone selling price method are provided for certain situations involving discounts and (or) variable consideration that can be shown to be related to one or more (but less than all) performance obligations. While there are some similarities between the guidance in ASC 606 related to allocating the transaction price to performance obligations and the guidance in the multipleelement arrangement models in legacy GAAP related to allocating the arrangement consideration, there are also many differences that could result in a different amount being allocated to a unit of account for revenue recognition purposes. For example, while today s general multiple-element arrangement model requires allocation of arrangement consideration using a relative selling price model, it does not provide exceptions related to allocating discounts or variable consideration. Standalone selling prices The standalone selling price of a performance obligation is the amount the entity charges (or would charge) when the distinct goods or services that make up the performance obligation (i.e., the underlying distinct goods or services) are sold on their own to a customer. Standalone selling prices are determined at contract inception and are not subsequently adjusted for changes in facts and circumstances. The best evidence of the standalone selling price of the underlying goods or services is the observable price charged by the entity for those goods or services when they are sold separately in similar circumstances to similar customers. Absent evidence of a directly observable standalone selling price, the entity is required to estimate a standalone selling price. In making this estimate, the entity should maximize observable inputs and consider all reasonably available and relevant information, which includes both entity-specific and market-specific information. While there are any number of approaches that could be used to estimate a standalone selling price, ASC 606 discusses the following three approaches: Adjusted market assessment approach. This approach identifies the price at which customers would be willing to buy the underlying goods or services on a standalone basis, which might include looking at prices charged by competitors for similar goods or services and making the appropriate entity-specific adjustments. Expected cost plus a margin approach. This approach builds up a standalone selling price for the underlying goods or services using the costs the entity expects to incur to provide the goods or services and adding an appropriate margin to those costs. Residual approach. This approach may only be used when: (a) one or more, but not all, of the performance obligations have underlying goods or services for which the standalone selling price(s) is highly variable or uncertain due to specific factors and (b) the standalone selling prices for the goods or services in the other performance obligations are observable. The difference (or residual) between the total transaction price and the observable standalone selling prices of those performance obligations with observable standalone selling prices is considered to be the estimated standalone selling price of the other performance obligation(s) (i.e., those with highly variable or uncertain standalone selling prices). 13